Exchange Traded Products (ETPs), including exchange traded funds (ETFs), Commodity Funds, and Exchange Traded Notes (ETNs) are a popular way to invest, with thousands of different products available to meet almost every imaginable investment goal. With such a wide variety of products available, it is important to remember that not all ETPs are created equal.
Leveraged and inverse, often collectively referred to as “geared”, ETPs do not work in the same way as simpler one-to-one trailing ETPs. These are complex investments that come with a unique set of risks. (While the focus of this Insight article is on targeted ETPs, there are also targeted mutual funds, which are similar.)
What are targeted ETPs?
Targeted ETPs generally seek to offer stated positive or negative multiples of the performance of a given benchmark or index over a given period of time, such as a day or a month. Among most of the leveraged ETPs currently listed, the positive leverage factors are 1.5x, 2x and 3x (i.e. one and a half, two and three times) and the inverse factors are -0.5x, -1x, – 2x and -3x. The vast majority of targeted ETPs have a daily leveraged or inverse target and reset their exposure factors each day. This means that the stated leverage or inverse factor target they seek to provide is restricted to a single trading day, typically measured from the close of trading on one day to the close of trading on the next day.
People are also reading…
The goal of a Leveraged ETP with a daily reset is to provide that degree of leveraged or reverse exposure for that single period, and more importantly, not for longer (or shorter) periods. (Similarly, a leveraged ETP with a monthly target is designed to provide that leveraged or reverse exposure over a specified monthly period.) Holding a leveraged ETP for a period shorter or longer than its target can lead to performance that may deviate significantly from the daily target.
An example of a targeted ETP is a 2x daily target leveraged ETF that aims to generate twice the return, positive or negative, of the S&P 500 on any given day. If the S&P 500 gains 2 percent in one day, the product would aim to generate a 4 percent gain. However, such a product is not designed to provide twice the return of the index over longer periods.
Another example is an inverse ETF that seeks to deliver -1x, or the opposite, of the return of the Nasdaq 100 Index. This ETF aims to deliver a return that is the exact opposite of what the index returns (either positive or negative) in a certain day. If the Nasdaq 100 closed 1.5 percent higher, the Inverse ETF would try to post a 1.5 percent loss. If the index closes down 2 percent, the ETF should post a 2 percent gain.
Some inverse ETPs seek to offer a multiple of the opposite of a given index’s performance, typically -2x or -3x, over a given period of time. An example of such a product is an ETF that seeks to generate -3x the daily return of the NYSE FANG+ Index. If the FANG+ index falls 3 percent on any given day, investors in the ETF can expect gains equal to three times the index’s percentage loss, or 9 percent. On the other hand, if the index gains 3 percent in one day, the ETF should post a 9 percent loss.
To achieve their stated returns, leveraged and inverse ETPs often use a variety of investment strategies, including swaps, futures, and other derivatives, as well as potentially long or short positions in securities. Note that targeted ETNs, which provide similar leveraged and inverse exposures, do not have an underlying portfolio of assets, but rather are debt issued by a financial institution.
Since most targeted ETPs are only designed to achieve the leveraged or inverse target set daily, they make no promises about how their returns will compare over a longer period. Returns may differ significantly from the performance (or the inverse of the performance) of their underlying index or benchmark over the same time period, which can make these products risky long-term or even medium-term investments, especially in volatile investments. markets. While such products may be held for periods that do not align with stated objectives, in general such positions should be closely monitored and used by investors who understand what the products are designed for and how they may behave in different market environments.
a closer look
Let’s say that at the close of business on Monday, you hold a $100 share of an index-linked 2x ETP with a value of 100. At the close of business on Tuesday, the index is down 10 percent to 90, resulting in at a 20 percent loss for the ETP, reducing its value to $80. Then on Wednesday, the index closes down 10 percent at 99, resulting in a 20 percent gain for the ETP. However, 20 percent of $80 is only $16, which means the value of the ETP is now $96.
On both days, the ETP achieved its stated target and produced daily returns that were twice the returns of the daily index. But over the course of these days, the index lost just 1 percent, while the 2x Leveraged ETP lost 4 percent. That means that in just a couple of days, the ETP lost four times as much as the index, not just twice (representing four times actual leverage instead of two). However, this is not a “tracking error” as the ETP met its daily target.
things to consider
Some ETPs, like targeted ETPs, can be tricky. Before you invest, be sure to ask:
- How does ETP achieve its stated goals? And what are the risks? Ask, and make sure you understand, what the products are designed for and how they may behave in different market environments (for example, in a volatile market), as well as the techniques the ETP uses to achieve its objectives and the risks involved.
- What happens if I hold a targeted ETP for more than one trading day? While there may be trading and hedging strategies that justify holding leveraged and inverse ETPs for more than a day, investors with an intermediate or long time horizon should carefully consider whether these products are appropriate for their portfolio. You could incur losses even if the underlying index’s long-term performance is up for a Leveraged ETP or down for an Inverse ETP.
- Is there a risk that a leveraged ETP will miss its set daily target? There is always a risk that not all leveraged or inverse ETPs will hit their stated target on any given trading day. Make sure you understand the impact this could have on your portfolio’s performance, given your goals and risk tolerance.
- What are the fees and expenses? Leveraged or inverse ETPs can be more expensive than traditional ETPs. Use FINRA fund analyzer to estimate the impact of fees and expenses on your investment.
- What are the tax consequences? Leveraged or inverse ETPs can be less tax efficient than traditional ETFs, in part because daily resets can cause the ETP to make significant short-term capital gains that may not be offset by a loss. There may be additional tax-related issues, so it is important to check with your tax advisor about the consequences of investing in these products.
The bottom line is that not all ETPs carry the same risks, and not all ETPs are suitable for all investors. Only trade if you are aware of and comfortable with the risks associated with these specialized products.
Subscribe to FINRA Investor Perspectives newsletter for more information on saving and investing.
10 Stocks We Like Better Than Walmart
When our award-winning team of analysts has investment advice, it’s worth listening to. After all, the newsletter they have published for over a decade, Motley Fool Stock Advisorhas tripled the market.*
They just revealed what they think are the top ten stocks for investors to buy right now…and Walmart wasn’t one of them! That’s right, they think these 10 stocks are even better buys.
Stock Advisor returns as of 02/14/21
The Motley Fool has a disclosure policy.